Sunday, May 22, 2016

Investment Selection: “Horses for Courses”


Each tool has its best single application. Each investment strategy has its best single application. In a similar fashion horse racing professional handicappers have often stated that there are "horses for courses." Meaning certain horses run better at certain race tracks than others. The most productive implementations of these choices are often the function of changed conditions from the immediate past.

As fund performance analysts and investment managers we have been urged to proclaim that past performance does not guarantee future results. Nevertheless all too many institutional and individual investors use past performance and particularly recent past performance as their primary selection screen. Many have taken this to the ultimate decision by investing the bulk of their money in Index funds.

The source of much of my analytical thinking came from handicapping horses races which is what track aficionados call analysis. The daily Bible reading for handicappers is the Daily Racing Form, (in  my day it was the Morning Telegraph.) In these pages the racing record of each horse is shown. From an analytical standpoint what I find of greater value than number of winning races are the conditions of the race to include which track, distance, time of the winner, time of the particular horse, weight carried relative to others, training times and conditions,  plus the names of the sire, dam, and sire of the dam and finally the conditions of the track. Professional analysts and portfolio managers can translate these factors into various selection screens in picking stocks, managers, and funds.

Selecting Investment Strategies for Different Portfolios

When choosing a bet in a race it is wise to start looking at the most popular which is called the favorite. The favorite is based on the most money being bet, not necessarily the horse that has the highest probability of winning. At the track and around the Investment Committee table most decisions are based on avoiding embarrassing losses, not optimizing the chances of large winnings.

The way I handle this challenge is not to bet on each race or every stock that is currently performing well. This tends to produce fairly concentrated portfolios of stocks, managers, and funds. The long-term (but evolving) focus is on a high aggregate dollar win/loss ratio. If you will, I am describing a contrarian bettor. However, as a contrarian, I should not disregard the weight of money bet on the favorite. This is even more true in investing than at the track because by definition popular stocks attract cash flow. In the short-term some investors can make them appear to be right.

Understanding the Investment Favorites

According to Moody’s* “Globally 10% of all public companies account for 80% of all profits.” Therefore these companies have less credit risk for their bonds. Also, almost by definition, they are large capitalization equities. With the goal of reducing the chances of losses, most investors prefer large-cap stocks or funds. This is particularly true for endowments. 

Endowments are one of the four TIMESPAN L PORTFOLIOS®, and depending upon on the needs of the account can be aggressively or conservatively invested.  Many of the standard endowment portfolio managers are getting frustrated as it has been a year on Monday since the S&P500 has hit a new high, and for the last four weeks the DJIA has been declining. (Perhaps there is some validity to the pre-air conditioning ditty of “Sell in May and go away.”)

The frustrated investors, the media pundits, and the various sales forces have not been paying attention to Charlie Munger, Warren Buffett, and their two investment associates. As a group, Berkshire Hathaway* has been selective long-term buyers of stocks and companies. As the oracles of Omaha have often said, they like declining markets for their long-term holdings. Despite what they recommend for others, they are not buying an S&P 500 Index, they are selectively buying a small collection of Large, Mid, and Small-Cap stocks.

I believe that size does not define a stock as a good investment, but due to size many stocks have increasing difficulty making progress. (This does not mean that investors are blind to the attractiveness of some Large-Caps in their recent purchases of Apple*, IBM, and Wells Fargo*.) One of the reasons that they are more active now than when there is more enthusiasm in the market is Charlie Munger’s belief that is wise to buy a good company at a reasonable price rather than a less good company at a good price.

Applying Betting Principles to The Preakness

In a postscript to my blog that commented on The Kentucky Derby,  I urged bettors not to bet on its winner to Win the second race of the Triple Crown for 3 year-olds. I suggested to find a good Place bet. (A Place bet pays off if the horse comes in first or second, a Show bet pays off if the horse comes in first, second or  third. The pool  of money that is used to payoff winning bets is divided into three parts for a Show ticket, two parts for a Place ticket and one part for the Winning ticket.  Thus it is normal that winning tickets pay more than Place tickets and Place tickets pay more than Show tickets.) I felt the dollar odds would be larger if the Derby winner came in first. This was before I knew that the track would be muddy on Saturday, and based on past experience was an advantage to the eventual winner. Racing luck and jockey skill  produced the result. Regardless of the change in track conditions, my suggestion to make a Place bet on a non-favorite was valid.  On a money basis a $2 Place bet paid $3.20 whereas the favorite, which came in third, paid $2.20.

*Stock owned in a managed private financial services fund and/or personally.

Question of the Week: What methods do you use when investing in Large-Caps and Small-Caps?
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A. Michael Lipper, C.F.A.,
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Sunday, May 15, 2016

Three Major Sources of Investment Losses


Essentially I am a student of investment performance. For the most part I use the global universe of mutual funds as my laboratory. In addition, I serve on a number of investment committees that employ external managers as well as own individual securities. Recently, I suggested that in addition to looking at the rank of our endowment performance that we isolate five to ten winners and a similar number of losers. I was much more interested in the second group. There were many similar characteristics of the winners however there were fewer in the laggards.

As an investment manager for serious investors my first job is to avoid losing large amounts of money for my clients. With this particular task in mind I have identified three main causes of many large portfolio losses.

Major Source # 1: Gross Domestic Product (GDP)

The academic definition of GDP is the sum of the goods and services produced within a national economy. From that top down level other economic projections are made by economists that in turn produce investment strategies of portfolio managers and strategists. There are numerous problems within this approach. First, much of the data collection going into the aggregate GDP number is flawed. The source is usually government data which can be easily manipulated for political purposes to such a significant degree that the former Premier of China indicated that he did not trust GDP as it was “man made.” He used other data produced by the private sector to help him guide the Chinese economy.

There are substantial portions of the US economy that go largely unreported. Not only is the “informal” or underground economy uncounted, the value produced by the volunteer sector is also unknown as is the work carried on within the home for no direct monetary compensation. Paul Samuelson, the great MIT economist and the author of one of my college economy text books pointed out that if a man married his maid and she continued to clean his home as his wife, the GDP would shrink because the maid’s income would no longer be counted.

In the modern world the production of GDP is done for political leaders to guide their economic policies. Because the politicians have most of their political power within their borders, they are essentially focused on domestic job creation. This is not the way consumers look at their purchases which are focused on quality, price, style, and availability from any acceptable source. Managers must manage both domestically produced products and imports and their relative prices. Investors need to follow their investments in companies that have both domestic and foreign activities as well as follow world trade flows and currency fluctuations.

Thus in the real world GDP is not of much use to us as consumers, managers, and investors. Therefore, be very careful of any manager that starts his/her investment strategy based on changes of the level of the GDP. That is not the real world and only useful in dealing with the politicians and the uninformed media.

Major Source # 2: Reported Earnings Per Share

As soon as earnings per share numbers are published, investors are bombarded with slews of “Non-GAAP” statistics often adjusting most of the operating numbers on the income statements. Managements want investors to focus on these adjusted numbers not the reported numbers and the differences can be meaningful, from a loss to a profit excusing some non-recurring occurrence. Managements are often getting paid through stock price changes, but the statistical services are using the reported numbers. So whether the stock and the market is cheap or expensive relative to earnings is a function of which set-off earnings are being used.

As a professional analyst, I prefer to focus on operating earnings excluding in many cases net interest income, but adding actual and additionally needed capital expenses. In essence I am looking to determine the net cash generation of the business after expenditures and debt service. Thus different investors can come up with different valuations from the same financial report. For the professional investor the published financial statement is the beginning of the analytical discussion not the end. Therefore, a manager that relies exclusively on reported earnings could be misleading both investors and him/herself as to the significance of the report.

Major Source # 3: Investment Predictions

Charlie Munger and Warren Buffett place very little reliance on economic or corporate predictions. This is contrary to most of the financial community which rotates, sometimes violently, on changes in predictions. Many studies of investors' behavior and particularly of their losses show that high levels of confidence as to the future can lead to poor results. If one emotionally needs to make predictions, make them often, but go back to the base case each time to see the nature of the differences and the strength of the prediction. The odds are that we will be wrong much more often in our predictions than in our analysis of the present. Our view of the past will be occasionally wrong as well.     

Applying this Week’s Thoughts

Each week Barron’s publishes a confidence index that compares the yields of the best (high quality) bonds and intermediate (lower investment grade) bonds. Over time if the relation between the yields widens, high quality stocks will rise. For the last several weeks that is exactly what is happening with the yields on the higher qualities being flat and the yields on the intermediates rising. Over the latest 12 months the high quality yields have dropped from 3.64% to 3.23% where as the intermediates’ yields have risen from 4.68% to 4.92%. The way I interpret the data, the intermediate yield gain is showing a measurable increase in an estimate of the default risk which to me is more significant than a somewhat larger decline in the best bonds’ yield. I am a little more confident in the analysis of what the present market is saying than I am in the future prediction.

Question of the week: How do you measure your confidence ?

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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Sunday, May 8, 2016

Mutual Funds for Users and Competitors


I have devoted my career to the study and use of mutual funds for my clients and family. Almost everyone that has been exposed to the media discussing investing has an idea about mutual funds. Just about every professional investor regardless of investment vehicle competes with mutual funds for talent, securities, and cash flow. Unfortunately be they the media, academics, regulators, general investors and even many mutual fund investors they have an incomplete and often flawed view of mutual funds. This is understandable as mutual funds start as a legal entity, not a group of people trying to accomplish an investment goal. The language of lawyers is designed to protect their paying clients, not to communicate users and bystanders.


We regularly use various types of vehicles to transport ourselves or other desirable objects such as water and freight. Staying with the vehicle analogy, your personal car, Uber or taxi ride, takes you to a specific planned location. A mutual fund is more like a bus. The bus takes a group of people, often strangers, from one planned location to another. Along the way passengers enter and leave to fulfill their private needs. The announced elements of the implied contract include expected times of departure and arrival, cost, and to be governed by more restrictive rules as to presumed safety. In a similar way mutual funds have a generalized statement of investment objective, a published price structure covering fees and expenses, regular reporting procedures, and more restrictive sets of rules usually promulgated by various regulators (SEC, IRS, DOL, various states, etc.) In my opinion these rules are more about what lawyers believe should be disclosed than about actual safety elements. Nevertheless they provide some useful information that are not provided to the same degree by other investment advisors or institutional investors.

Advantages of Mutual Funds

Mutual funds are the single most regulated investment vehicle and make both their performance and portfolios available for public disclosure. Many mutual fund management groups also advise pension and profit sharing plans, endowments, and separate accounts for wealthy individuals and families, plus in some cases hedge funds. Most often the media uses mutual fund reports as a clue what the institutional community is doing.

Thus, an element of misunderstanding occurs as mutual funds were originally designed for long-term investing not short-term trading. Mutual funds should be reviewed over long periods of falling and rising markets. Over these longer periods, it is rare for a fund to be a financial  failure; i.e., bankrupt. The reason for their longevity is they are often quite diversified in their portfolios. Just as diversified as the different types of people on the bus as distinct from a sole driver or a very small group of passengers who have more in common than those on the bus. This is one of the reasons that it is a bit foolish to compare the performance of an individual stock with most mutual funds. (More on this later when discussing funds vs. indices.)

Often investors in mutual funds do not appreciate for what they are paying. For many fund holders their monthly, quarterly, and annual statements represent a record of not only their performance but their ownership for tax and estate purposes. Further, funds use their best judgments in voting the funds’ securities particularly in complex transactions. Fund owners are paying for a somewhat independent review of all of the fund’s activities including fees, expenses, and other elements of potential conflicts of interest. This independent review is not found in separate accounts including various types of retirement accounts.

Perhaps for some or all of the reasons mentioned, institutions which because of their size and presumed experience also choose to invest in mutual funds. According to the latest data from the US fund trade association, 13.46% of fund assets are held by institutional investors utilizing equity, fixed income, and money market funds.

Understanding Fund Flows

Various studies focusing on how our brains make decisions, (including financial decisions) indicate that external forces, often other people, cause us to choose various decisions that perhaps seem on the surface to be irrational. Thus it has often been said that mutual funds are not bought but sold. The sales person may be a human or electronic as well as an image that has been created through paid media or public relations.

Reasons Why a Human Advisor is Necessary

One of the disadvantages of owning funds without a human investment advisor consulting with the fund owner is that when personal or investment conditions change the owner does not have the cautionary warning as to the shifting of spending, investment strategy, or redeeming too early. Investors purchase funds to meet various goals and when they think their goals are being met their instinctive reaction is to redeem their fund shares. Thus I look at most redemptions of long-term funds as planned completions. In recent years the combination of forced early retirements, rising college tuition support, and gyrating home prices has, in my opinion, accelerated the rate of gross redemptions somewhat higher than what prior actuarial trends would have suggested.

Mutual Fund Macro-Economics

Because of the growing wealth of the US, particularly through population growth combined with rising real wages, the dollar value of new fund sales were larger than the redemptions, leading to an industry of growing net sales. This has not been true for the last several years, as the old growth model has flattened, but also for another reason. There is a change in the economics of selling funds. Many distributors; i.e., brokerage firms, have materially reduced their efforts of selling funds. (Charles Schwab*  has just announced that it is no longer going to sell load funds.)
* Held in the private financial services fund account that I manage.

To avoid being accused of churning their accounts, brokers and to a degree investment advisers have kept fund positions with average ownership turnover rates dropping well below the historic norm of five years. Some funds are experiencing turnover periods of two years or less. When capital is freed from funds it is redirected into more currently profitable products for the intermediary, including sales of private equity, various other underwriting, real estate related, and margined securities. Numerous fund groups have interviewed redeeming fund shareholders, perhaps the they are being too polite, but they do not detect a large amount of dissatisfaction with funds during these interviews. Thus, I have come to believe that what we are witnessing is part of the economic cycle as well as a change in industry economics that is evolving.

Funds Should Be Compared with Funds Not Securities Indices

One of the reasons my old firm was successful in convincing the independent directors of funds is that they recognized that the funds that they responsible for operated under different constraints than indices as shown below:
Find Central Tendency      
A legal creation to comply with SEC, IRS, Treasury, Federal Reserve,  FINRA, and regulations of various US states
No prudential requirements
Court-overseen limits as to portfolio composition
No tax implications.            
Tax influenced decisions
Accept last price
Unrepresentative prices can be discarded
Not audited
Audited and examined
No diversification limits
5% and 10% rules for most funds
No cash
Cash required to meet redemptions and opportunities
“All Weather”
Time span and market conditions oriented

If I am being too cryptic please contact me for further explanation.

In our managed accounts we use index or passive funds along with active funds when we are seeking winners. There are a number of reasons to use passive accounts including the following:

  •        Greater liquidity to meet sudden cash needs in periods of turmoil.
  •        To lower the weighted average cost of the account when using higher fee active managers.
  •        At times and in some investment objectives greater diversification is needed.
  •        At perceived bottoms when active funds have too much cash.

Active funds have a place in our client accounts for the following reasons:

  •        There are times that a portfolio of growing operating earnings that uses excess cash for acquisitions of under-used properties or activities is wise.
  •        When we are seeking extreme concentration.      
  •        When we are looking at undervalued voting interests.
  •        When we want to bet on successful managers who need to prove that they can recover their winning ways.
  •        When we are reviewing cyclical companies and asset classes in anticipation of near-term turnaround.
  •       When passive vehicles won’t do the job.

As one can see, our management does not key off of near-term performance, but rather properly positioned portfolios and research capability for future (not present) markets.

In my personal account I mix both active and passive funds along with individual securities, mainly in the financial services businesses.
P.S.  I have been asked about my reaction to the winner of the Kentucky Derby. Regular readers know that much of my investment thinking began at the race track. I was out of the country and did not see this year’s Derby, thus I will briefly focus on betting the next race for an undefeated colt using my standard mutual fund  performance  analysis approach.  The next race, presumably, The Preakness, will send the colt off at very short, probably prohibitive odds.
Racing as with investing always is subject to unknown and unknowable factors. Thus  I would not place a bet on the Kentucky Derby winner, but look for a longer odds horse to place or come in the first two spot
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Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.